Posts Tagged The Crisis of 2008

This is the final part in my series on how the financial crisis is relevant for economics (here are parts 1, 2, 3, 4, 5 & 6). Each part explores an argument economists have made against the charge that the crisis exposed fundamental failings of their discipline, with the quality of the arguments increasing as the series goes on. This post discusses probably the strongest claim that economists can make about the crisis: they do understand it, and any previous failures were simply due to inattention or misapplication, rather than fundamental problems with the theory itself.

Argument #7: “Economists had the tools in place, but we overspecialised and systemic problems caught us off guard.”

Raghuram Rajan was probably the first to take this sort of line, arguing that overspecialisation prevented economists from using the tools they had to foresee and deal with the crisis. But while Rajan’s piece also made a number of other criticisms of economics, over time the discipline seems to have reasserted this argument more strongly: not too long ago, Paul Krugman argued that although “few economists saw the crisis coming…basic textbook macroeconomics has performed very well”. Similarly, Tim Harford claimed at an INET conference last year that the tools necessary to understand the crisis already existed in mainstream economics, and the problem was simply one of knowing when and how to use them. He compared financial crises to engineering disasters, which were understandable using current knowledge but happened nonetheless, due to negligence or oversight on the part of the engineers.

So how true is this claim? Certainly, a number of economic models exist for understanding things like panics, liquidity problems and moral hazard. The most well known of these are the Diamond-Dybvig (DD) model of bank runs – which shows what happens when banks have liquid liabilities (such as demand deposits) which must be available at any time, but have illiquid assets (such as loans) which are not fully convertible to cash on demand – and the Akerlof-Romer (AR) model of financial ‘looting’, which shows that deposit guarantees may create moral hazard as investors gamble other peoples’ money. If you combine tools like these, which help us understand the financial sector, with tools like IS/LM, which tell us how to escape a downturn once it happens, in theory you have a pretty solid set of tools for dealing with the recent crisis.

The first objection I have to these models is that many of their insights could be considered trivial, or at least common sense. The DD model came to the conclusion that deposit insurance might be helpful way to prevent bank runs, which is hardly a revelation considering it came 50 years after FDR and the general public figured out the same thing. The AR model came to the conclusion that deposit insurance and limited liability might create perverse incentives as banks gamble ‘other peoples money’, which again must have been obvious to the policymakers who put Glass-Steagal and other financial regulations in place. Perhaps this point is a little harsh, and I don’t want to overstate it: on the whole, these papers are asking important questions, and in the case of AR they answer them well. Nevertheless, there’s no point in economic theory if it can’t tell us things we didn’t already know. Even the idea that central banks should provide emergency liquidity to banks in trouble is quite obvious, and it predates modern economic theory by a good while.

However, this is not the most important point. The issue I have with these models is that in many of them everything interesting happens outside the model. In Krugman’s favoured IS/LM, a ‘crisis’ is represented by a simple shift in the IS curve, which in English means that a decline in production is cause by…a decline in production. Where this decline came from is presumably a matter for outside the model. Even the most sophisticated macroeconomic models often follow a similar tack, merely describing what happens when the economy suffers from a shock, without exploring possible causes for the shock. Likewise, the DD model suggests bank runs happen because everyone panics, but what causes these panics is not explored: it is assumed depositors’ expectations are exogenous, whether fixed or following a stochastic (random) pattern. Yet studies such as Mishkin (1991) find that bank runs generally follow periods of stress elsewhere in the economy, a fact which DD simply cannot capture.

Economic models are narrowly focused like this because they are generally designed to answer straightforward questions about causality: does the minimum wage cause unemployment; does expansionary fiscal policy cause growth; does a mismatch between illiquid assets and liquid liabilities cause bank runs. But the crisis was an endogenously generated process in which different aspects of the economy – the housing market, the financial sector, government policy – combined to create something bigger than the sum of its parts, and in which it is not possible to isolate a single cause. Consider: the collapse of Lehman Brothers may have triggered the worst of the crisis, but was it really to blame? The economy was already in a fragile place due to systemic trends that can’t necessarily be traced to a single law, institution or actor. Just like the murder of Franz Ferdinand in World War 1, we have to look beyond the immediate and focus on the general if we truly want to understand what happened.

To sum up, the economists above want to argue that they are only culpable insofar as they overspecialised and failed to focus on the right areas in this particular instance. However, the reason for this was not just because of personal myopia; it’s because their chosen methodology means they lack the tools to do so. A model of one aspect of the economy which takes the effect of other areas as exogenous will fail to detect potential positive feedback loops and emergent properties. A model which takes the crisis itself as an exogenous ‘shock’ is even worse, and in many ways is hardly a model of the crisis at all, since it offers no understanding of why crises might happen in the first place. Are there alternatives? I have previously written about how post-Keynesian and Marxist models offer more comprehensive understandings of the financial crisis and antecedent decades; I shan’t repeat myself here. Other promising areas include network theory, evolutionary economics and Agent-Based Modelling. All of these share that they take the system as a whole instead of focusing on isolated mechanics.

Conclusion

I see the crisis in economics as a shock (!!) which hits macroeconomics hard and reverberates throughout the discipline. Regardless of the pleas of some, such events can be seen coming, and they cannot be handwaved away as part of an overall upward trend. And even if individual economists are not in control of policy, key economists have substantial influence, not to mention the theories and ideas in economics as a whole. Recent developments in macroeconomics still leave a lot to be desired, while previously existing tools suffer from similar problems: a lack of holism; a wooden insistence on microfoundations; and attempt to understand everything in terms of simplistic causal links, often relative to a frictionless baseline. Finally, although many areas of economics are not directly indicted by the crisis, many of them share key problems with macroeconomics, and as such the crisis should prompt at least a degree of introspection throughout the discipline.

This is part 6 in my series on how the financial crisis is relevant for economics (here are parts 1, 2, 3, 4 & 5). Each part explores an argument economists have made against the charge that the crisis exposed fundamental failings of their discipline. This post discusses the argument that the ‘crisis in economics’ is confined only to macroeconomics, which is actually minority, so attacking all of economics is wrongheaded.

Argument #6: “Sure, modern macroeconomics is pretty weak. But most economists don’t even work on macro, so they are unaffected.”

Quite a lot of economists consider the debate about the financial crisis irrelevant to what they do. After all, why should a crisis at the macro level invalidate econometrics, game theory or auction theory? Attacking these fields and others for the recession is like blaming mechanical engineers for a bridge collapse. In fact, many economists hold macro in the same (low) esteem as the public: Daniel Hamermesh goes so far as to claim that “most of what the macro guys do in academia is just worthless rubbish”, but adds that the kind of field he works in “has contributed tremendously and continues to contribute”. Even the discipline’s most vehement defenders are willing to concede macroeconomics is bunk.

There is a considerable amount of truth to this view. While there may be critiques of all areas in economics, the claim that the financial crisis is what’s thrown them into disrepute is a non sequitur. Critics should therefore be careful to distinguish macroeconomists from their colleagues when (rightly) dismissing the former’s failure to deal with the crisis. Nevertheless, there are two major ways in which the failings of macroeconomics are symptomatic of more general problems with economic theory, so the discipline as a whole cannot be let off the hook.

The first is a lack of holism. A large amount of economic theories are built in an abstract theoretical vacuum, with little reference to what is happening around the individual agent. But the importance of the macroeconomy for behaviour in specific sectors or by specific actors cannot be ignored. For example, if you drop the macroeconomic assumption of full employment, this affects theories in areas from public goods provision to labour markets to Walrasian equilibrium. Consumers’ and firms’ expectations are strongly informed by the macroeconomic and political environment around them. Considering the effects of political institutions such as unions on the labour market, but ignoring their broader political role, can create narrow and misguided conclusions about their efficacy. New Institutional economics often takes ‘institutions’ as exogenous, failing to consider to two-way interaction between institutions and agents. The in-vogue ‘Randomised Control Trial’ restricts the economic environment to such a degree that it’s questionablewhether one can generalise the results at all. And so forth.

Don’t get me wrong: there is an obvious case for different areas of economics being separate from one another: taking certain parameters as exogenous to look at a certain area, and using different tools for different areas. But even the most specialised fields should never forget the broader scope and context of their ideas, and this should be reflected in the theoretical approach. Thomas Piketty’s Capital is a shining example of how to intertwine theory, history, statistics and politics to build a better understanding of capitalism. Another is the attempt by ecological economists to place the economy in its environmental context, rather than simply taking resource endowments as a given and assuming pollution just sort of…disappears, save for its monetary cost. Minsky’s Financial Instability Hypothesis shows one way to make an effective link between the behaviour of investors and broader economic performance, integrating finance and macroeconomics. Overspecialisation may cause economists to miss these key insights.

The second issue is that many of the problems with macroeconomics can be applied to, or are relevant for, other areas of the discipline. One of the key complaints about macroeconomics – that it relies on microfoundations – is a problem precisely because it imports unrealisticassumptions about economic behaviour from microeconomics. The problem of having an abundance of abstract models, each seeking to explain one or two ‘things’, but with no real way to tell which model is applicable and when, applies not just to macroeconomics but also to behavioural economics, microeconomics, oligopoly theory. Endogenous money, which is central to macroeconomists’ lack of understanding of the crisis, also has major implications for finance. To reuse my above analogy, you might well be concerned about mechanical engineers after a bridge collapse if they largely relied on the same methods used by the civil engineers.

Your average economist is probably right to point out that the public’s ire should be focused not on them, but on macroeconomics. However, this doesn’t mean that they are immune from the serious questions the crisis raised about the methodology, assumptions and ethics of the field. It’s a case-by-case matter which areas are impacted and by how much, but any attempt to box off macroeconomic theory entirely should be resisted. There’s plenty of room for fruitful debate about all areas of economic theory, much of which will benefit from being informed by the shortcomings of economic theory as exposed by the financial crisis.

This is part 5 in my series on how the financial crisis is relevant for economics (parts 1, 2, 3 & 4 are here). Each part explores an argument economists have made against the charge that the crisis exposed fundamental failings of their discipline. This post explores the possibility that macroeconomics, even if it failed before the crisis, has responded to its critics and is moving forward.

Argument #5: “We got this one wrong, sure, but we’ve made (or are making) progress in macroeconomics, so there’s no need for a fundamental rethink.”

Many macroeconomists deserve credit for their mea culpa and subsequent refocus following the financial crisis. Nevertheless, the nature of the rethink, particularly the unwillingness to abandon certain modelling techniques and ideas, leads me to question whether progress can be made without a more fundamental upheaval. To see why, it will help to have a brief overview of how macro models work.

In macroeconomic models, the optimisation of agents means that economic outcomes such as prices, quantities, wages and rents adjust to the conditions imposed by input parameters such as preferences, technology and demographics. A consequence of this is that sustained inefficiency, unemployment and other chaotic behaviour usually occur when something ‘gets in the way’ of this adjustment. Hence economists introduce ad hoc modifications such as sticky prices, shocks and transaction costs to generate sub-optimal behaviour: for example, if a firm’s cost of changing prices exceeds the benefit, prices will not be changed and the outcome will not be Pareto efficient. Since there are countless ways in which the world ‘deviates’ from the perfectly competitive baseline, it’s mathematically troublesome (or impossible) to include every possible friction. The result is that macroeconomists tend to decide which frictions are important based on real world experience: since the crisis, the focus has been on finance. On the surface this sounds fine – who isn’t for informing our models with experience? However, it is my contention that this approach does not offer us any more understanding than would experience alone.

Perhaps an analogy will illustrate this better. I was once walking past a field of cows as it began to rain, and I noticed some of them start to sit down. It occurred to me that there was no use them doing this after the storm started; they are supposed to give us adequate warning by sitting down before it happens. Sitting down during a storm is just telling us what we already know. Similarly, although the models used by economists and policy makers did not predict and could not account for the crisis before it happened, they have since built models that try to do so. They generally do this by attributing the crisis to frictions that revealed themselves to be important during the crisis. Ex post, a friction can always be found to make models behave a certain way, but the models do not make identifying the source of problems before they happen any easier, and they don’t add much afterwards, either – we certainly didn’t need economists to tell us finance was important following 2008. In other words, when a storm comes, macroeconomists promptly sit down and declare that they’ve solved the problem of understanding storms. It becomes difficult to escape the circularity of defining the relevant friction by its outcome, hence stripping the idea of ‘frictions’ of predictive power or falsifiability.

There is also the open question of whether understanding the impact of a ‘friction’ relative to a perfectly competitive baseline entails understanding its impact in the real world. As theorists from Joe Stiglitz to Yanis Varoufakis have argued, neoclassical economics is trapped in a permanent fight against indeterminacy: the quest to understand things relative to a perfectly competitive, microfounded baseline leads to aggregation problems and intractable complexities that, if included, result in “anything goes” conclusions. To put in another way, the real world is so complex and full of frictions that whichever mechanics would be driving the perfectly competitive model are swamped. The actions of individual agents are so intertwined that their aggregate behaviour cannot be predicted from each of their ‘objective functions’. Subsequently, our knowledge of the real world must be informed by either models which use different methodologies or, more crucially, by historical experience.

Finally, the ad hoc approach also contradicts another key aspect of contemporary macroeconomics: microfoundations. The typical justification for these is that, to use the words of the ECB, they impose “theoretical discipline” and are “less subject to the Lucas critique” than a simple VAR, Old Keynesian model or another more aggregative framework. Yet even if we take those propositions to be true, the modifications and frictions that are so crucial to making the models more realistic are often not microfounded, sometimes taking the form of entirely arbitrary, exogenous constraints. Even worse is when the mechanism is profoundly unrealistic, such as prices being sticky because firms are randomly unable to change them for some reason. In other words, macroeconomics starts by sacrificing realism in the name of rigour, but reality forces it in the opposite direction, and the end result is that it has neither.

Macroeconomists may well defend their approach as just a ‘story telling‘ approach, from which they can draw lessons but which isn’t meant to hold in the same manner as engineering theory. Perhaps this is defensible in itself, but (a) personally, I’d hope for better and (b) in practice, this seems to mean each economists can pick and choose whichever story they want to tell based on their prior political beliefs. If macroeconomists are content conversing in mathematical fables, they should keep these conversations to themselves and refrain from forecasting or using them to inform policy. Until then, I’ll rely on macroeconomic frameworks which are less mathematically ‘sophisticated’, but which generate ex ante predictions that cover a wide range of observations, and which do not rely on the invocation of special frictions to explain persistent deviations from these predictions.

This is part 4 in my series on economics and the crisis, which asks whether economics is really responsible for policy, and if so, how these policies may have contributed to the financial crisis. Here are parts 1, 2 & 3.

Argument #4: “Mainstream economics cannot be blamed for politicians inflating housing bubbles/pursuing austerity/deregulating the financial sector; our models generally go against this. Clearly, we do not have that much influence over policy.”

This defence really raises two questions. The first is whether or not economic theory has had a major influence on policy. The second is whether or not this influence, if it exists, is culpable in creating the financial crisis.

The first is, in my opinion, easily answered in the affirmative. While it’s entirely understandable that the majority of academic economists would scoff at the idea that they effect policy, this doesn’t have to be the case for economic theory itself to hold sway among governments. After all, economics graduates are highly sought after and employed in policymaking positions. Famous economists lunch with the president; textbooks and macroeconomic papers are full of policy discussions; prize-winning economists such as Bob Shiller acknowledge that a “problem with economics is that it is necessarily focused on policy, rather than discovery of fundamentals.” It’s hard to imagine powerful institutions such as Central Banks, the World Bank or the IMF functioning with advice from any but economists, and government organisations are even set up based on new ideas coming out of economics. Economics is the language in which the media discuss policy: demand, stimulus, markets, etcetera. I could go on.

However, as economists like to remind us, there’s no reason to believe that advice based on mainstream economic theory should have led to the types of ‘free market’ policies typically implicated in the financial crisis and its aftermath. Even a basic economics education will leave you with an awareness of things like information asymmetry, moral hazard and externalities, and few economists support wanton deregulation of the financial sector. Modern macroeconomics is loosely pro-stimulus, not pro-austerity. So what’s going on?

First, it should be noted that not only ‘free market’ thinking was implicated in the crisis. Central Banks around the world used inflation targeting, based on the New Keynesian idea that this would be sufficient to achieve macroeconomic stability, which blinded them to problems brewing in the financial sector. What’s more, the approach to regulation favoured by economics was, not atypically, quite narrow and didn’t favour systemic thinking. For example, I have previously spoken about Value at Risk (VaR) regulation, which forces firms to sell off assets when markets are volatile and hence increase their insurance against risk. However, while this looks good from the perspective of individual firms, it worsens systemic risk because the asset sell-offs result in increased volatility. Overall, the reductionist nature of economic theory tended to blind policymakers to systemic problems and made them focus on the wrong variables, things they might not have done if they’d been familiar with more holistic viewpoints.

Having said this, it’s clear that at the heart of the financial crisis were lax regulatory policies, justified by a belief in the self-stabilising power of financial markets. And while a majority of individual economists may not endorse such a view, theoretical frameworks or ‘ways of thinking‘ came out of economics which were used to justify this deregulation. Whether or not efficient markets, perfect competition, rational expectations and other theories which imply financial markets will run smoothly are endorsed by most economists, the fact that they are common knowledge in economics (and usually the benchmark for more complex analysis) is significant. As I’ve argued before, familiarity with economic theory lends itself to a pro-market view, even if a lot of modern work is done pushing the core framework away from this. And as I’ve argued before, the nuances of this work are often lost in popular translation, as the elegance of the most Panglossian theories proves too tempting when economists speak to the public. Alternative theories which use different starting points for analysis, such as input-output matrices, sectoral balances, or class struggle, would help to combat the deeply ingrained nature of the neoclassical theories.

This issue does not necessarily fit into a narrow ‘government versus market’ policy perspective. Instead, the point is that acknowledging different approaches in economic theory can give us a different way of thinking about policy, illuminating rather than obfuscating debates. A key complaint about economics graduates is that they have overly narrow, abstract tools, so the enemy is not so much any particular approach as it is one sided thinking. Providing both economics students and professional economists with an awareness of different theories, as well as making economics more politically, historically and ethically engaged, would hopefully at least temper the zeal and enthusiasm with which pet policies are recommended, and partially dislodge whatever pedestal economics currently sits on as a rationale for policy.

This is part 3 in my series on why and how the 2008 financial crisis is relevant to economics. The first instalment discussed why the good times during the boom are no excuse for the bad times during the bust. The second instalment discussed use of the Efficient Markets Hypothesis (EMH) to defend economists’ inability to forecast the movements of financial markets. This instalment discusses the more general proposition that crises are events whose prediction is outside the grasp of anyone, including economists.

This argumentinitiallysounds quite persuasive: the economy is complex, and the future inherently unknowable, so we shouldn’t expect economists to predict the future any better than we’d expect from other analysts of complex systems. However, the argument is actually a straw man of what critics mean when they say economists didn’t foresee the recent crisis. It confuses conditional predictions of the form “if you don’t do something about x, y might happen” with oracle-esque predictions of the form “y is going to happen on December 2003”. Nobody should have expected the details of crisis – many of which were hidden – to be foreseen, and much less a prediction about exactly which banks would fail and when. Instead, what is expected is for economists to have the key indicators right and know how to deal with them, to be alert to the possibility of crisis at all times – even in seemingly tranquil periods – and to have measures in place to cushion the blow should a crisis occur.

In fact, those who study earthquakes or hurricanes do ‘predict’ them in the above sense: they understand where they’re most likely to occur (for example near fault lines), and at roughly which frequency, time and magnitude. They also have an idea of how best to combat them: areas which are prone to earthquakes and hurricanes – funding permitting – have dwellings built in such a way that they can withstand such occurrences. They understand why disasters happen, and their models tell us why they cannot be predicted. For example, it is common knowledge that weather forecasts get less accurate the further away they are due to the sensitivity of the model to initial conditions, a point based on complex mathematics but communicated well by meteorologists (not to mention that weather forecasts are improving all the time).

While there’s been a lot of kerfuffle over exactly who ‘predicted’ the crisis and what that means, the most important point is that those who did warn of a crisis like the one we’re going through identified key mechanisms (debt build up, asset price bubbles, global imbalances) and argued that, unless these processes were combated, we’d be in danger. I appreciate that the ‘stopped clock’ problem really is a problem: there are so many people predicting crises that eventually, one of them will seem to be right. However, this is easily countered by using the same framework to make predictions outside the crisis (predictions in the general sense of the word, not just about the future). For example, Peter Schiff predicted a financial crisis quite a lot like the one we’ve been through, but he also predicted hyperinflation, suggesting that his model is wrong in some way. Conversely, endogenous money models are consistent with both the financial crisis and the subsequent weak effects of monetary stimulus: since money is created as debt, private debt can have major effects on the economy, and since banks do not lend based on reserves, there’s no reason for an increased monetary base do produce inflation.

Finally, while natural disasters are almost entirely exogenous phenomena, the economy is a social system, so we have a degree of control over it, both individually and collectively. It’s perhaps a testament to how the neoclassical approach naturalises the economic system that some economists feel recessions can be compared to natural disasters (not that this would mean they had no responsibility for alleviating their effects). Since economic models are frequently used to inform government policy, it’s quite clear that economists appreciate this point; however, since they often admit they don’t really understand what causes recessions, they are doing the equivalent of sending us up in toy planes. It’s fair to say that you don’t fully understand the economy; it’s quite another thing to say this, then recommend ways to manage it. But the relationship between economists and policy is a matter for the next part of the series.

This is part 2 in my series on why and how the 2008 financial crisis is relevant to economics. The first instalment discussed why the good times during the boom are no excuse for the bad times during the bust. This instalment discusses the use of the Efficient Markets Hypothesis (EMH) to defend economists’ inability to forecast the movements of financial markets, hereafter referred to as the ‘EMH-twist’.

Argument #2: ““The EMH claims that crises are unpredictable, so the fact that economists didn’t predict the crisis is not a problem for economics at all.”

As far as I’m aware, this argument was first used by John Cochrane, and it has reappeared multiple times since then: for example, it was more recently referenced by Andrew Lilco, who was sadly echoed by the generally infallible Chris Dillow. The idea is that financial markets process new information faster than any one individual, government or institution could, and so for most people they may seem to behave unpredictably. However, economists can not be expected to understand these sudden movements better than anyone else, so expecting them to foresee market crashes is absurd. As Cochrane puts it, “it makes no sense whatsoever to try to discredit efﬁcient market theory in ﬁnance because its followers didn’t see the crash coming”.

However, this logic is completely circular. The mere fact that a theory exists which claims crises are unpredictable does not mean that, if a crisis is not predicted – particularly by the proponents of said theory – this shows the theory is correct. If the EMH had, to the best of our knowledge, been shown to be correct, then the EMH-twist might hold some water, but we must establish this truth separately from the the fact its proponents didn’t predict the crisis (David Glasner recently made a similar point about the ubiquitous use of rational expectations in macroeconomics). While Cochrane does claim that the central tenet of the EMH “is probably the best-tested proposition in all the social sciences”, he fails to reference supporting evidence, and in fact goes on to add substantial qualifications to the empirical record of the EMH, admitting that market volatility might happen “because people are prey to bursts of irrational optimism and pessimism”.

It is not necessarily my aim to establish the truth or falsity of the EMH here: it has been discussedextensivelyelsewhere. However, there are a couple of key tests for whether or not it applies to 2008. The first is whether or not anybody – both adherents and detractors of the theory – foresaw the crisis. While the EMH claims nobody could, this is clearly wrong: some people in finance made a lot of money; some economists not only called it but had frameworks that explained it well once it happened; quite a few people (even mainstream economists) at least noted the existence of a housing bubble. The EMH can attribute these predictions to simple luck, but now we’re back to circularity: assume the EMH is true, then appeal to it to rationalise any possible market movement. The second test of the EMH, since it depends on new information to trigger volatility, is to ask exactly what new information became available just before the crash. However, the financial instruments key to 2008 were used by investment banks for a good few years prior to the crash, so it’s quite difficult to claim that new information about these suddenly became available in 2007-8. Instead, what happened was a collective realisation that everyone knew very little about the products they’d been trading, resulting in a classic panic.

In fairness, there is an element of truth to the EMH-twist. Financial markets are incredibly difficult to understand, and the argument that economists don’t yet understand them, along with a mea culpa, might be acceptable – there are many things natural scientists still don’t understand, such as dark matter, or what happened ‘before’ the big bang. However, the EMH-twist as used by Cochrane et al is phrased more strongly: it is the assertion that economists can’t and shouldn’t understand the movements of financial markets, simply because the EMH allows them to wash their hands of the task. We wouldn’t accept this kind of attitude from any other field, so I can’t help but feel Cochrane’s claim that “the economist’s job is not to ‘explain’ market ﬂuctuations after the fact” can only be met with: “then what is the economists’ job, exactly?”

For critics of mainstream economics, the 2008 financial crisis represents the final nail in the coffin for a paradigm that should have died decades ago. Not only did economists fail to see it coming, they can’t agree on how to get past it and they have yet to produce a model that can understand it fully. On the other hand, economists tend to see things quite differently – in my experience, your average economist will concede that although the crisis is a challenge, it’s a challenge that has limited implications for the field as a whole. Some go even further and argue that it is all but irrelevant, whether due to progress being made in the field or because the crisis represents a fundamentally unforeseeable event in a complex world.

I have been compiling the most common lines used to defend economic theory after the crisis, and will consider each of them in turn in a series of 7 short posts (it was originally going to be one long post, but it got too long). I’ve started with what I consider the weakest argument, with the quality increasing as the series goes on. Hopefully this will be a useful resource to further debate and prevent heterodox and mainstream economists (and the public) talking past each other. Let me note that I do not intend these arguments as simple ‘rebuttals’ of every point (though it is of some, especially the weaker ones), but as a cumulative critique. Neither am I accusing all economists of endorsing all of the arguments presented here (especially the weaker ones).

Argument #1: “We did a great job in the boom!”

I’ve seen this argument floating around, and it actually takes two forms. The first, most infamously used by Alan Greenspan – and subsequently mocked by bloggers – is a political defense of boom-bust, or even capitalism itself: the crisis, and others like it, are just noise around a general trend of progression, and we should be thankful for this progression instead of focusing on such minor hiccups. The second form is more of a defence of economic theory: since the theory does a good job of explaining/predicting the boom periods, which apply most of the time, it’s at least partially absolved of failing to ‘predict’ the behaviour of the economy. Both forms of the argument suffer from the same problems.

First, something which is expected to do a certain job – whether it’s an economic system or the economists who study it – is expected to do this job all the time. If an engineer designs a bridge, you don’t expect it to stand up most of the time. If your partner promises to be faithful, you don’t expect them to do so most of the time. If your stock broker promises to make money but loses it after an asset bubble bursts, you won’t be comforted by the fact that they were making money before the bubble burst. And if an economic system, or set of policies, promise to deliver stability, employment and growth, then the fact that it fails to do so every 7 years means that it is not achieving its stated objectives. In other words, the “invisible hand” cannot be acquitted of the charge of failing to do its job by arguing it only fails to do its job every so often.

Second, the argument implies there was no causal link between the boom and the bust, so the stable period can be understood as separate from the unstable period. Yet if the boom and the bust are caused by the same process, then understanding one entails understanding the other. In this case, the same webs of credit which fuelled the boom created enormous problems once the bubble burst and people found their incomes scarce relative to their accumulated debts. Models which failed to spot this process in its first phase inevitably missed (and misdiagnosed) the second phase. As above, the job of macroeconomic models is to understand the economy, which entails understanding it at all times, not just when nothing is going wrong – which is when we need them least.

As a final note, I can’t help but wonder if this argument, even in its general political form, has roots in economic theory. Economic models (such as the Solow Growth Model) often treat the boom as the ‘underlying’ trend, buffeted only by exogenous shocks or slowed/stopped by frictions. A lot of the major macroeconomic frameworks (such as Infinite Horizons or Overlapping Generations models) have two main possibilities: a steady-state equilibrium path, or complete breakdown. In other words, either things are going well or they aren’t – and if they aren’t, it’s usually because of an easily identifiable mechanism, one which constitutes a “notably rare exception” to the underlying mechanics of the model. Such a mentality implies problems, including recessions, are not of major analytical interest, or are at least easily diagnosed and remedied by a well-targeted policy. Subsequently, those versed in economic theory may have trouble envisaging a more complex process, whereby a seemingly tranquil period can contain the seeds of its own demise. This causes a mental separation of the boom and the bust periods, resulting in a failure to deal with either.

I have new post on Pieria, following up on mainstream macro and secular stagnation. The beginning is a restatement of my critique of EM/a response to Simon Wren-Lewis, but the main nub of the post is (hopefully) a more constructive effort at macroeconomics, from a heterodox perspective:

There are two major heterodox theories which help to understand both the 2008 crisis and the so-called period of ‘secular stagnation’ before and after it happened: Karl Marx’s Tendency of the Rate of Profit to Fall (TRPF), and Hyman Minsky’sFinancial Instability Hypothesis (FIH). I expect that neither of these would qualify as ‘precise’ or ‘rigorous’ enough for mainstream economists – and I’ve no doubt the mere mention of Marx will have some reaching for the Black Book of Communism – but the models are relatively simple, offer an understanding of key mechanisms and also make empirically testable predictions. What’s more, they do not merely isolate abstract mechanisms, but form a general explanation of the trends in the global economy over the past few decades (both individually, but even moreso when combined). Marx’s declining RoP serves as a material underpinning for why secular stagnation and financialisation get started, while Minsky’s FIH offers an excellent description of how they evolve.

I have two points that I wanted to add, but thought they would clog up the main post:

First, in my previous post, I referenced Stock-Flow Consistent models as one promising future avenue for fully-fledged macroeconomic modelling, a successor to DSGE. Other candidates might includeAgent-Based Modelling, models in econophysics or Steve Keen’ssystems dynamics approach. However, let me say that – as far as I’m aware – none of these approaches yet reach the kind of level I’m asking of them. I endorse them on the basis that they have more realistic foundations, and have had fewer intellectual resources poured into them than macroeconomic models, so they warrant further exploration. But for now, I believe macroeconomics should walk before it can run: clearly stated, falsifiable theories, which lean on maths where needed but do not insist on using it no matter what, are better than elaborate, precisely stated theories which are so abstract it’s hard to determine how they are relevant at all, let alone falsify them.

Second, these are just two examples, coloured no doubt by my affiliation with what you might call left-heterodox schools of thought. However, I’m sure Austrian economics is quite compatible with the idea of secular stagnation, since their theory centres around how credit expansion and/or low interest rates cause a misallocation of investment, resulting in unsustainable bubbles. I leave it to those more knowledgeable about Austrian economics than me to explore this in detail.

I recently stumbled upon a reddit post called ‘A collection of links every critic of economics should read.‘ One of the weaker links is a defence of economists post-crisis by Gilles Saint-Paul. It doesn’t argue that economists actually did a good job foreseeing the crisis; nor does it argue they have made substantial changes since the crisis. It argues that the crisis is irrelevant. It is, frankly, an exercise in confirmation bias and special pleading, and must be fisked in the name of all that is good and holy.

Saint-Paul starts by exploring the purpose of economists:

If they are academics, they are supposed to move the frontier of research by providing new theories, methodologies, and empirical findings.

Yes, all in the name of explaining what is happening in the real world! If economists claim their discipline is anything more than collective mathematical navel gazing, then their models must have real world corroboration. If this is not yet the case, then progress should be in that direction. Saint-Paul is apparently happy with a situation where economists devise new theories and all nod and stroke their beards, in complete isolation from the real world.

He continues:

If [economists] work for a public administration, they will quite often evaluate policies.

Hopefully ones that prevent or cushion financial crises, surely? Wait – apparently this is not a major consideration:

One might think that since economists did not forecast the crisis, they are useless. It would be equally ridiculous to say that doctors were useless since they did not forecast AIDS or mad cow disease.

AIDs and mad cow disease were random mutations of existing diseases and so could not have been foreseen. Financial crises are repeated and have occurred throughout history. They demonstrate clear, repeated patterns: debt build ups; asset inflation; slow recoveries. Yet despite this, doctors have made more progress on AIDs and MCD in a few decades than economists have on financial crises in a few centuries. It was worrying enough that DSGE models were unable to model the Great Depression, but given that ‘it’ has now happened again, under very similar circumstances, you’d think that alarm bells might be going off inside the discipline.

Saint-Paul now starts to defend economics at its most absurd:

One example of a consistent theory is the Black-Scholes option pricing model. Upon its introduction, the theory was adopted by market participants to price options, and thus became a correct model of pricing precisely because people knew it.

Similarly, any macroeconomic theory that, in the midst of the housing bubble, would have predicted a financial crisis two years ahead with certainty would have triggered, by virtue of speculation, an immediate stock market crash and a spiral of de-leveraging and de-intermediation which would have depressed investment and consumption. In other words, the crisis would have happened immediately, not in two years, thus invalidating the theory.

‘A crisis will happen if these steps are not taken to prevent it’ is not the same as ‘Lehman Brothers will collapse for certain on September 15th, 2008.’ Saint-Paul confuses different levels, and types of, prediction. Nobody is suggesting economists should give us a precise date. What people are suggesting is that, by now, economists should know the key causal factors of financial crises and give advice on how to prevent them.

Saint-Paul charges critics with:

…[ignoring] that economics is a science that interacts with the object it is studying.

How he thinks this is beyond me, seeing as the whole criticism is that policies designed by economists had a hand in causing the crash. Predictably, he goes on to state a ‘hard’ version of the Lucas Critique, the go-to argument for economists defending their microfoundations:

Economic knowledge is diffused throughout society and eventually affects the behaviour of economic agents. This in turn alters the working of the economy. Therefore, a model can only be correct if it is consistent with its own feedback effect on how the economy works. An economic theory that does not pass this test may work for a while, but it will turn out to be incorrect as soon as it is widely believed and implemented in the actual plans of firms and consumers. Paradoxically, the only chance for such a theory to be correct is for most people to ignore it.

It is reasonable to suggest policy will have some impact on the behaviour of economic agents. It is absurd to suggest this will always have the effect of rendering the policy (model) useless (irrelevant). It is even more absurd to suggest that we can ever design a model that sidesteps this problem completely. What we have is a continually changing relationship between policy and economic behaviour, and this must be taken into account when designing policy. This doesn’t imply we should fall back on economist’s preferred methods, despite a clear empirical failure.

Saint-Paul moves on – now, apparently, the problem is not that economist’s theories don’t behave like reality, but that reality doesn’t behave like economist’s theories:

In other words, if market participants had been more literate in, or more trustful of economics, the asset bubbles and the crisis might have been avoided.

If only everyone believed, then everything would be fine! Obviously, the simple counterpart to this is that many investors and banks did believe in the EMH or some variant of it, yet, as always, reality had the final say, as happened with the aforementioned Black-Scholes equation.

Saint-Paul now attempts to play the ‘get out of reality completely’ card:

While it is valuable to understand how the economy actually works, it is also valuable to understand how it would behave in an equilibrium situation where the agents’ knowledge of the right model of the economy is consistent with that model, which is what we call a “rational expectations equilibrium”. Just because such equilibria do not describe past data well does not mean they are useless abstraction. Their descriptive failure tells us something about the economy being in an unstable regime, and their predictions tell is something about what a stable regime looks like.

Basically, Saint-Paul is arguing that economic models should be unfalsifiable. Since we can hazard a guess that he isn’t too bothered about unrealistic assumptions, given the models he is defending, and since he clearly doesn’t care about predictions either, he has successfully jumped the shark. Economists want to be left alone to build their models which posit conditions which are never fulfilled in the real world, and that’s final!

As if this wasn’t enough, he proceeds to castigate the idea that economists should even attempt to expand their horizons:

The problem with the “broad picture” approach, regardless of the intellectual quality of those contributions, is that it mostly rests on unproven claims and mechanisms. And in many cases, one is merely speculating that this or that could happen, without even offering a detailed causal chain of events that would rigorously convince the reader that this is an actual possibility.

Note what Saint-Paul means by “detailed causal chain of events.” He means microfoundations. But he is not concerned about whether these microfoundations actually resemble real world mechanics, only that whether they are a “possibility.” To him, the mere validity of an economic argument means that it has been ‘proven,’ regardless of its soundness. In other words: economists shouldn’t be approximately right, but precisely wrong.

Saint-Paul concludes by rejecting the idea that financial crises can be modeled and foreseen:

This presumption may be proven wrong, but to my knowledge proponents of alternative approaches have not yet succeeded in offering us an operational framework with a stronger predictive power.

I hope – and actually believe – that most economists don’t believe that the crisis is irrelevant for their discipline. I’m sure few would endorse the caricature of a view presented here by Saint-Paul. Nevertheless, it is common for economists to suggest that the crisis was unforeseeable: a rare event that cannot be modeled because the economy is too ‘complex.’ This must be combated. Financial crises are actually (unfortunately) relatively frequent occurrences with clear, discernible patterns drawing them together. To paraphrase Hyman Minsky: a macroeconomic model must necessarily be able to find itself in financial crisis, otherwise it is not a model of the real world.

In chapter 14 of Debunking Economics, Steve Keen walks us through the macroeconomic model he has developed in recent years, and discusses the implications its conclusions might have for policy. The model is in its early stages, and Keen himself says there are “many aspects of the model of which [he is] critical.” Nonetheless, it is a promising start to developing an alternative to the dominant DSGE method.

Keen’s is a model of a pure credit economy, with three aggregated agents: workers, firms, and bankers. Instead of focusing on preferences, individuals and market clearing, it focuses on the flow of funds between different sectors. Bankers create their own money in the form of loans*, which at this stage they are only allowed to lend to firms. The firms pay the workers and the interest on the loans, whilst the bankers and workers consume the output of the firms.

The crucial sector here, is, of course, banking, which few neoclassical models include explicitly, as they believe finance plays the role of intermediation between savers and borrowers. However, in Keen’s model the banks are central. He disaggregates them into several accounts: a vault in which to store notes; a safe into which interest is paid and out of which bankers are paid; a loan ledger; firm deposits and worker deposits. The flows between the various agents and accounts are then determined by some arbitrary coefficients, which Keen uses simply to determine whether the model will ‘work’ (i.e. not break down). Each flow (e.g. wages; consumption) is determined by a constant times a stock (e.g. firm’s deposits; worker’s deposits).

This is the point at which economists might scream ‘Lucas Critique,’ but Keen’s comment from an earlier chapter, that is absurd to suggest that any change in policy will have the effect of neutralising arbitrary parameters, applies. Furthermore, there is no theory that is policy-independent, so whilst we must examine the relationship between policy and reality, we cannot render our models immune to it by micro founding them. In any case, the model is in its early stages, and there is plenty of room for adding complexity.

Keen uses this basic model to explore what effect bank bailouts will have. Quelle surprise, bank bailouts have the effect of increasing loans slightly, and benefitting bankers, but don’t do much for the real economy. Conversely, bailing out firms and workers creates a better result for everyone except…the bankers! A small data point can be found in support of this in Australia, where the government bailed out everyone over 18 with $1000, and the economy has performed better than those where the banks have been bailed out. Obviously there are a multitude of conflicting factors, but Keen’s hypothesis does not seem at all unreasonable when taking recent events as whole.

The interesting thing about Keen’s model is that a ‘Great Moderation’ and a ‘Great Recession’ are simply two parts of the same debt-driven process, rather than a ‘black swan’ or some other such event. Debt to GDP rises exponentially in a period of relative tranquility, and this is followed by a huge crash and mass unemployment. A substantial part of this difference from the core DSGE models is created simply by adding banks as explicit agents.

Keen has since developed his model further – he has included ‘Ponzi’ lending, sticky wages/price (which actually stabilise the economy) and a variety of other factors. There is plenty of scope for adding more to the model, such as an exogenously set interest rate with a central bank, but for now the core alone seems to be able to generate behaviour that closely resembles that of a capitalist economy: one prone to cyclical breakdown and intermittent financial crises, not due to any particular ‘friction,’ but due to the inherent characteristics of the system. This should be enough to get any empirically driven economists to pay attention, whether they agree or disagree with the mechanics of the model.